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March 27, 2012

All Alternative Funds Are Not Created Equal: How to Tell

During the past few years, much as been written (some of it by me) about the advantages of alternative investments in client portfolios. Apparently, advisors and the public have been listening. According to Morningstar, in 2007 alternative mutual funds brought in only $2.8 billion; by 2010, inflows had grown six-fold to $18.8 billion.

The reasons behind this meteoric success aren’t hard to figure: during the decade ending March 31, 2010, the S&P 500 Index (total return) was down 6.36%, or 0.66% per year, while hedge funds (as measured by the HFRI Fund Weighted Composite Index) were up 77%, or 5.9% a year, and managed futures mutual funds (as measured by the Altegris 40 Index) were up 115%, or 8.0% annually.

What’s more, non-correlated alternative funds are well suited to allocated portfolios: From January 1997 to Jan 2012, Managed futures had a -0.15 negative correlation to the S&P. During this same period, the S&P had an annualized standard deviation of 16.5% vs. 10.5% for managed futures and 6.1% for Global Macro funds, all of which can reduce portfolio risk dramatically.

Another reason for alternative funds’ recent success is that in recent years, hedge fund managers have warmed to the mutual fund format. “Many hedge fund managers who wouldn’t have considered this before, are doing it today,” said Jon Sundt (left), president and CEO of Altegris Advisors, which manages some $3.4 billion in alternative funds. “Some hedge funds showed massive redemptions. And there’s been fee compression; Hedge fund managers who used to get 1% plus 20% of their gains, are now willing to work for a flat fee. Also, after the credit crisis, long/short managers are using lower leverage: less than two to one, which is required by mutual funds.”

Unfortunately, while the mutual fund structure is easier for advisors to manage in client portfolios, many advisors are not aware that there are critical differences between funds that use alternative strategies and funds holding more traditional asset classes.

To help advisors better understand these differences, Altegris recently launched the Altegris Academy, an advisor-only website which offers detailed information on alternatives including the fundamentals and more sophisticated ‘How To’ solutions. The site contains articles, white papers, videos and analytical tools to better incorporate alternatives into client portfolios.

According to Sundt, advisors’ failure to understand the differences of alternative funds can lead them to make any combination of four major mistakes:

Advisors often choose the wrong managers.

“There is a lot of junk out there,” said Sundt, including “long/short and macro funds with underlying managers with questionable track records, and without a deep infrastructure to support them. With a large cap value fund, for instance, when the index goes up, every large cap manager goes up. If you get the asset class right, you’ve won.”

But in the alternative world, he points out, there’s not as much correlation between managers: one fund can be long, while another fund is short. “That creates a huge disparity between similar funds,” Sundt says. “. One long/short fund might be up 40% while another is down 40%. It’s really important to focus on talent.”Sometimes firms will have a sound track record, but for too short a period. Sundt recommends that each of a fund’s sub managers have a 10-year track record. For managers with a shorter history, Altegris analytics enables advisors to simulate their performance over a longer period.

Some strategies aren’t viable for ‘40 Act mutual funds.

Usually the issue here is one of liquidity. Distressed debt, event anticipation, and private equity are investment strategies that typically don’t work well in a mutual fund structure.

Strategies that do work well include Managed futures, global currencies, global macro, long/short equity, emerging markets, and small cap and micro cap, provided stocks held have sufficient liquidity.

Most hedge fund managers don’t want to replicate their hedge fund in a mutual fund.

“They’d lose their high-paying hedge fund customers,” says Sundt. “Top managers want access to top money that mutual funds can bring in, but they don’t want to jeopardize their franchise and disclose all their holdings.” To get around this problem, Altegris and other mutual fund sponsors combine multiple hedge fund managers into each mutual fund. That way, when fund holdings are disclosed, it’s not clear who holds what. And investors who want a portfolio managed by one specific manager still will be drawn to his hedge fund.

Fees can be higher.

“If you find a good manager, they are going to want bigger money,” says Sundt. “They can’t get their usual 1 and 20 in a mutual fund, but we can pay them up to 2%.”

Yes, that’s more than your typical mutual fund. But for managers who have a record of beating the market with lower risk, and low correlation, it maybe one of the best investments that advisors—and their clients—make in the coming years.